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Chapter 1: Introduction to Managerial Economics

2001 I.P.L. Png and C.W.J. Cheng 1

Chapter1

Introduction to Managerial Economics

CHAPTER SUMMARY

Managerial economics is the science of directing scarce resources to manage costeffectively. It consists of three branches: competitive markets, market power, andimperfect markets. A market consists of buyers and sellers that communicate with eachother for voluntary exchange. Whether a market is local or global, the same managerialeconomics apply.

A seller with market power will have freedom to choose suppliers, set prices, anduse advertising to influence demand. A market is imperfect when one party directlyconveys a benefit or cost to others, or when one party has better information thanothers.

An organization must decide its vertical and horizontal boundaries. For effectivemanagement, it is important to distinguish marginal from average values and stocksfrom flows. Managerial economics applies models that are necessarily less thancompletely realistic. Typically, a model focuses on one issue, holding other things equal.

KEY CONCEPTS

managerial economics average value horizontal boundariesmicroeconomics stock marketmacroeconomics flow industryeconomic model other things equal market powermarginal value vertical boundaries imperfect market

GENERAL CHAPTER OBJECTIVES

1. Define managerial economics and introduce students to the typical issuesencountered in the field.

2. Discuss the scope and methodology of managerial economics.3. Distinguish a marginal concept from its average and a stock concept from a flow.

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4. Describe the importance of the "other things equal" assumption in managerialeconomic analysis.

5. Describe what constitutes a market, distinguish competitive from non-competitivemarkets, and discuss imperfect markets.

6. Emphasize the globalization of markets.

NOTES

1. Definition. Managerial economics is the science of directing scarce resources tomanage cost effectively.

2.Application. Managerial economics applies to:(a) Businesses (such as decisions in relation to customers including pricing and

advertising; suppliers; competitors or the internal workings of the

organization), nonprofit organizations, and households.(b) The old economy and new economy in essentially the same way except for

two distinctive aspects of the new economy: the importance of networkeffects and scale and scope economies.

i. network effects in demand the benefit provided by a service dependson the total number of other users, e.g., when only one person hademail, she had no one to communicate with, but with 100 mm userson line, the demand for Internet services mushroomed.

ii. scale and scope economies scaleability is the degree to which scaleand scope of a business can be increased without a corresponding

increase in costs, e.g., the information in Yahoo is eminently scaleable(the same information can serve 100 as well as 100 mm users) and toserve a larger number of users, Yahoo needs only increase thecapacity of its computers and links.

iii. Note: the term open technology (of the Internet) refers to therelatively free admission of developers of content and applications.

(c) Both global and local markets.3. Scope.

(a) Microeconomics the study of individual economic behavior where resourcesare costly, e.g., how consumers respond to changes in prices and income, how

businesses decide on employment and sales, voters behavior and setting oftax policy.

(b) Managerial economies the application of microeconomics to managerialissues (a scope more limited than microeconomics).

(c) Macroeconomics the study of aggregate economic variables directly (asopposed to the aggregation of individual consumers and businesses), e.g.,issues relating to interest and exchange rates, inflation, unemployment, importand export policies.

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4. Methodology.(a) Fundamental premise - economic behavior is systematic and therefore can be

studied. Systematic economic behavior means individuals share commonmotivations and behave systematically in making economic choices, i.e, a

person who faces the same choices at two different times will behave in thesame way both times.(b) Economic model a concise description of behavior and outcomes:

i. focuses on particular issues and key variables (e.g., price, salary),omits considerable information, hence unrealistic at times;

ii. constructed by inductive reasoning;iii. to be tested with empirical data and revised as appropriate.

5. Basic concepts.(a) Margin vis a vis average variables in managerial economics analyses.

i. marginal value of a variable the change in the variable associatedwith a unit increase in a driver, e.g., amount earned by working onemore hour;

ii. average value of a variable the total value of the variable divided bythe total quantity of a driver, e.g., total pay divided by total no. ofhours worked;

iii. driver the independent variable, e.g., no. of hours worked;iv. the marginal value of a variable may be less that, equal to, or greater

than the average value, depending on whether the marginal value isdecreasing, constant or increasing with respect to the driver;

v. if the marginal value of a variable is greater than its average value, theaverage value increases, and vice versa.(b) Stocks and flows.

i. stock the quantity at a specific point in time, measured in units ofthe item, e.g., items on a balance sheet (assets and liabilities), theworlds oil reserves in the beginning of a year;

ii. Flow the change in stock over some period of time, measured inunits per time period e.g., items on an income statement (receipts andexpenses), the worlds current production of oil per day.

(c) Holding other things equal the assumption that all other relevant factors donot change, and is made so that changes due to the factor being studied maybe examined independently of those other factors. Having analysed the

effects of each factor, they can be put together for the complete picture.

6. Organizational boundaries.(a) Organizations include businesses, non-profits and households.(b) Vertical boundaries delineate activities closer to or further from the end user.(c) Horizontal boundaries - relate to economies of scale (rate of production or

delivery of a good or service) and scope (range of different items produced ordelivered).

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(d) Organizations which are members of the same industry may choose differentvertical and horizontal boundaries.

7. Competitive markets.(a) Markets.i. a market consists of buyers and sellers that communicate with one

another for voluntary exchange. It is not limited by physical structure.ii. in markets for consumer products, the buyers are households and

sellers are businesses.iii. in markets for industrial products, both buyers and sellers are

businesses.iv. in markets for human resources, buyers are businesses and sellers are

households.v. Note: an industry is made up of businesses engaged in the production

or delivery of the same or similar items.

(b) Competitive markets.i. markets with many buyers and many sellers, where buyers provide the

demand and sellers provide the supply, e.g., the silver market.ii. the demand-supply model - basic starting point of managerial

economics, the model describes the systematic effect of changes inprices and other economic variables on buyers and sellers, and theinteraction of these choices.

(c) Non-competitive markets a market in which market power exists.8. Market power.

(a)

Market power - the ability of a buyer or seller to influence market conditions.A seller with market power will have the freedom to choose suppliers, setprices and influence demand.

(b) Businesses with market power, whether buyers or sellers, still need tounderstand and manage their costs.

(c) In addition to managing costs, sellers with market power need to manage theirdemand through price, advertising, and policy toward competitors.

9. Imperfect Market.(a) Imperfect market - where one party directly conveys a benefit or cost to

others, or where one party has better information than others.

(b) The challenge is to resolve the imperfection and be cost-effective.(c) Imperfections can also arise within an organization, and hence, another issue

in managerial economics is how to structure incentives and organizations.

10.Local vis a vis global markets.(a) Local markets owing to relatively high costs of communication and trade,

some markets are local, e.g., housing, groceries. The price in one local marketis independent of prices in other local markets.

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(b) Global markets - owing to relatively low costs of communication and trade,some markets are global, e.g., mining, shipping, financial services. The priceof an item with a global market in one place will move together with the prieselsewhere.

(c) Whether a market is local or global, the same managerial economic principlesapply.(d) Note: Falling costs of communication and trade are causing more markets to

be more integrated across geographical border enabling the opportunity tosell in new markets as well as global sourcing. Foreign sources may providecheaper skilled labor, specialized resources, or superior quality, resulting inlower production costs and/or improved quality.

ANSWERS TO PROGRESS CHECKS

1A. The managerial economics of the new economy is much the same as that of theold economy with two aspects being more important network effects in demand andscale and scope economies.

1B. Vertical boundaries delineate activities closer to or further from the end user.Horizontal boundaries define the scale and scope of operations.

ANSWERS TO REVIEW QUESTIONS

1. Marketing over the Internet is a scaleable activity. Delivery through UPS issomewhat scaleable: UPS already incurs the fixed cost of an international collectionand distribution network; it may be willing to give Amazon bulk discounts for largervolumes of business.

2. Number of cars in service January 2002 + production + imports exports scrappage during 2002 = Number of cars in service January 2003. Number of carsin service is stock; other variables are flows.

3. [omitted].4. No, models must be less than completely realistic to be useful.5. (a) Average price per minute = (210 + 120 x 4)/5 = 138 yen per minute. (b) Price

of marginal minute = 120 yen.

6. (a) Flow; (b) Stock; (c) Stock.

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7. (a) The electricity market includes buyers and sellers. (b) The electricityindustry consists of sellers only.

8. (a) False. (b) False.9. [omitted].10.If there are scale economies, the organization could product at a lower cost on a

larger scale, which means wider horizontal boundaries; and vice versa.

11. Yes. Horizontal boundaries: how many product categories should it sell? Verticalboundaries: should it operate its own warehouses and delivery service?

12.Intel has relatively more market power.13.(b).14.Both (a) and (b).15.Competitive markets have large numbers of buyers and sellers, none of which can

influence market conditions. By contrast, a buyer or seller with market power caninfluence market conditions. A market is imperfect if one party directly conveysbenefits or costs to others, or if one party has better information than another.

WORKED ANSWER TO DISCUSSION QUESTION

Jupiter Car Rental offers two schemes for rental of a compact car. It charges $60 perday for an unlimited mileage plan, and $40 per day for a time-and-mileage plan with100 free miles plus 20 cents a mile for mileage in excess of the free allowance.

a. For a customer who plans to drive 50 miles, which is the cheaper plan. What arethe average and marginal costs per mile of rental? (The marginal cost is thecost of an additional mile of usage.)

b. For a customer who plans to drive 150 miles, which is the cheaper plan. Whatare the average and marginal costs per mile of rental?

c. If Jupiter raises the basic charge for the time-and-mileage plan to $44 per day,how would that affect the average and marginal costs for a customer who drives50 miles?

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Answer(a)It is helpful to sketch the total rental cost as a function of the mileage (see

figure below). The breakeven between the two plans is at 200 miles per day.For 50 miles, the time-and-mileage plan is cheaper. Average cost = $40/50 =

80 cents per mile. Marginal cost = 0.

200100

$60

$40

0

unlimited milea e lan

time-and-mileage plan

Totalcost($)

Quantity (miles per day)

(b) For the 150 mile customer, the time-and-mileage plan is still cheaper. Averagecost = $(40 + 0.2 x 50)/150 = 33 cents per mile; marginal cost = 20 cents permile.

(c)After the increase in the basic charge, the average cost = $(44 + 0.2 x 50)/150= 36 cents per mile, while marginal cost = 20 cents per mile. The increase inthe basic charge doesnt affect the marginal cost.

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